Global Financial Systems Chapter 11 Currency Markets. Part b · • In eﬀect, speculating against...

Global Financial Systems © 2019 Jon Danielsson, page 1 of 57

Inflows Overvaluing Undervaluing Reserve Math

Global Financial Systems

Chapter 11

Currency Markets. Part b

Jon Danielsson London School of Economics© 2019

To accompanyGlobal Financial Systems: Stability and Risk

http://www.globalfinancialsystems.org/

Published by Pearson 2013

Version 6.0, August 2019



Book and slides

• The tables and graphs arethe same as in the book

• See the book forreferences to original datasources

• Updated versions of theslides can be downloadedfrom the book web pagewww.globalfinancialsystems.org



Where to invest and borrow

• Often best if savers invest in own country and currency• Eliminates currency risk (e.g. hot money and sudden

stop)

• But at least 3 reasons not to1. Diversification for savers

• why many EMEs simultaneously export and importcapital

2. Cost of borrowing3. Amount of credit



Who borrows

• Matters whether borrower is an exporter, earning inforeign currency

• Not advisable for domestically oriented firms orhouseholds to borrow abroad

• whether directly in foreign currency from banks• or in domestic currency from domestic banks who

borrow abroad

• Think of Asia 1998, and several European countries (e.g.Poland) before 2008

• households and very small SMEs would borrow in foreigncurrency

• caused significant pain for them and their banks in thecrisis



Policy options

• Strong pressures for foreign borrowing

• Expansionary and makes everybody feel wealthier

• So what is the CB to do?• raise interest rates (see next plot)• inflow capital controls• restrict who can borrow in foreign currency



The risk-taking channel of the currency

appreciation

Central bankrates ↑

Inflow from carrytraders

Demand for foreigncurrency loans ↑

Banks intermediateFX loans

Currencystrengthens

Positive wealtheffect

Economystrengthens



Global bank retrenchment

• The inflow mechanism has changed since the crises

• Before banks were the primary intermediary• e.g. NYC banks lending to domestic banks who lent to

domestic agents

• But there has been a major retrenchment of global banks

• They have been leaving countries and reducing theiroperations

• And when not, may be required to establish separatelycapitalized subsidiaries



Financing from debt securities issuance

• Borrowers in EMEs have easier access to internationalcapital markets than before

• Consequently, the debt issuance of EME corporate inoffshore financial centers (like NYC) has increased rapidly

1. Lower interest rates2. Positive feedback between inflows and FX appreciation3. Lower administrative, legal and tax costs4. Offshore markets are also more developed for

sub-investment grade bonds5. Preferential tax system for foreign investors



Outstanding international securitiesDeveloping countries, all borrowers

1990 1995 2000 2005 2010 2015

5

10

20

50

100

200

500

1000

2000

US

D b

illio

n

China − nationalityglobal residenceglobal nationality



Turkish lira/Euro

2000 2005 2010 2015

0.5e6

0.75e6

1e6

1.25e6

1.5e6

1.75e6

2

3

4

5

6

7



Current account balance

• Net trade in goods and services, net earnings oncross-border investments, and net transfer payments

• Positive current account balance: a net lender to the restof the world

• Negative current account balance: a net borrower fromthe rest of the world



Current account balance/GDP

2000 2005 2010 2015

TURDEUEA19ITAGRC−15%

−10%

−5%

0%

5%



Recent policies

• Credit is increasingly directed

• Policy rate is very low as believed that high interest ratesare inflationary

• Government and financial sector USD exposure rapidlyincreasing

• Vulnerability to FX



Turkey. International debt securitiesin USD and EUR. GDP USD 851 bn.

2000 2005 2010 2015

0

50

100

150

US

D b

illio

ns

GovernmentBanksNon−financial



Overvaluing



Overvaluingit just happens

• Often because a country is fighting high inflation or hasresorted to printing money to finance itself

• Fixing the exchange rate may be a way to fight inflation

• In the short run makes consumers, and hence voters,happy because it makes imported goods artificially cheap

• In the longer run it hurts exporters who are no longercompetitive



Often ends in speculative attacks

• Speculators, who usually are well connected localcompanies, observe this and seek to export the domesticcurrency

• In effect, speculating against the currency regime

• The government may give in or resort to capital controlsor multiple exchange rates

• The latter two are often a recipe for corruption becausethose giving permission to import or buy currencies atcheaper rates will reap artificial profits

• All of this suggests that it is virtually impossible forgovernment to maintain an artificially strong exchangerate for long without resorting to very costly measures



Asian crisis 1998

• Chapter 6 of book

• The then, (now returned) PM of Malaysia blamed foreignspeculators for attacking its currency

• Similar said in Korea, Indonesia, Thailand

• But data shows it was the well connected local familieswho attacked first

• While foreign speculators stuck with currency



Frequency of currency crisis

0

5

10

15

20

25

1975 1980 1985 1990 1995 2000 2005



The aftermath — Currency crises

• 3 years after a currency crisis, the level of GDP isbetween 2% and 6% lower than if there had been no crisis

• The losses tend to materialize before the currencycollapses

• Output growth tends to slow down prior to and in theyear of the currency crisis

• After the currency collapse, positive growth rates seem tobe the norm

• The economic costs of a currency collapse do not appearto arise from the collapse of the currency itself but fromnegative fundamentals

• But the government is often thrown out of power



Argentina GDP per capita ranking

60

50

40

30

20

10

1

1880 1900 1920 1940 1960 1980 2000



Argentina — Background

• Argentina was one of the riches countries until the middleof the last century, now on par with or below poorestcountries in EU

• Experienced currency crises, hyperinflation, sovereigndefault in the second half of last century

• High inflation rate persisted until the early 90s

• In 1991 the government adopted a currency board atparity to the dollar

• Prices stabilize quickly and inflation is brought downrapidly



The peso depreciation

1990 1995 2000 2005

1

10

100

1000

10000



The 90s

• With low inflation, Argentina saw strong growth in the90s

• Persistent budget deficits and fiscal problems continuedbut were masked by the strong growth performance

• In the late 90s, Asia, Russia and Brazil were all hit by acrisis and reacted with a devaluation of their currencies

• At the same time the dollar appreciated strongly

• Making the Argentinean peso look overvalued



The crisis

• Debt as a ratio of GDP increased even in boom times

• Growth unsustainable

• Argentina plunges into recession in 1999 driven by loss of

export competitiveness due to the overvalued peso

• The government facing an election responds by increasing

fiscal spending (AKA fiscal stimulus)

• Fiscal federalism — regions borrow, center does nowknow or can’t control

• Recent echoes in e.g. Spain and China



• As growth stalls, the government resorts to expansionary

fiscal policy causing the debt ratio to surge

• Investors get nervous and start pulling out capital

• As capital outflows increase, the government finds itdifficult to service its debt

• Devaluation not an option due to the currency board

• Large part of the debt is denominated in dollars

• Government continues with expansionary fiscal policy,heading for disaster (sound familiar?)



Reasons

• Vulnerable to external shocks because fiscal policyincompatible with a fixed exchange rate regime

• The dollar peg eliminated monetary policy as an optionand put strong restrictions on fiscal policy to keep debtsufficiently low to avoid an overvaluation of the peso

• Prudent fiscal policy was also important to maintain thecredibility of the currency board (stimulus)

• The government never got its finances under control andwhen faced with a crisis, responded with an expansionaryfiscal policy

• The fiscal policy of expansion was the result of politicalinstitutions pushing to commit more fiscal resources thanthey had



Analysis

• Everybody knew it was unsustainable

• Government used up all reserves

• Markets anticipated drop

• Capital controls

• ADR (American depository receipts) market classicexample of how agents bypass restrictions



Post-crisis policies — Inflation

• Export tax on beef (to lower domestic prices)

• Worked in short run, but production soon collapsed

• Banned measuring inflation



Governments’ Undervaluationof Foreign Exchange



Undervaluing — “Beggar thy neighbor”

• Attempt to make other countries subsidize your industry

• “Beggar thy neighbor” policies

• Uses domestic money to buy foreign currency• a country overvaluing will run out of money• a country undervaluing can, at least in theory, intervene

indefinitely

• The effects of undervaluing the currency in the short runare to make imports more expensive and exports cheaper

• Subsidy given to exporters and foreign consumers paid forby domestic consumers and foreign competitor industry



Costs of undervaluing

• Makes other countries very unhappy

• Can lead to competitive devaluations, where countries inturn devalue their currencies

• High inflation and huge disruption to domestic industries

• A country not engaging in such practices may end upbeing the strongest at the end

• Can also lead to restrictions on trade

• This can then spiral out of control

The Great Depression is a cautionary tale



Direct domestic effects

• Because industries are developed in a deliberatelylow–cost environment

• Companies adjust to this in their strategies, which mayhamper their long–term competitiveness

• If a country is forced to revalue its currency it then wouldbe very costly

• It would have been better for industry to develop in anappropriate exchange environment

• Hard to control credit

• Finally, such a policy can create hidden inflation thatdown the road makes a realignment a necessity



Compatibility of other policies

• Need to consider the compatibility FX policy with otherpolicy areas,

• monetary policy• fiscal policy• financial stability

• Japan’s dilemma• highest sovereign debt in the developed world• deflation• overvalued currency

Addressing any of those is likely to adversely affect theothers (deflation and FX pull the same way)



Currency war

• Deliberate policies of manipulating exchange ratesdownwards to increase domestic competitiveness haverecently been given the name “currency wars”

• Relates to reserve currencies



Plaza Accord

• 1980 to 1985 dollar had appreciated against yen and mark(next slide)

• France, West Germany, Japan, United States, UnitedKingdom

• Depreciate the dollar to yen and mark

• Signed in 1985 at the Plaza Hotel in NYC



Yen and DM to USD

160

180

200

220

240

260

280

2.0

2.5

3.0

yendm

1980 1981 1982 1983 1984 1985 1986

Pla

za



UK and France in 1920s and 1930s• In 1925, UK went back on the gold standard at pre–warrates

• France restored convertibility in 1926 at a devalued rate— an undervaluation of 15–20%

• France• export boom in France• gold flowed to France

• UK• balance of payments problems• recession

• Considerable friction between France and the UK

• France became increasingly uncompetitive, adjusted to aweak currency, found it difficult to re–adjust when over,causing significant political instability



The case of Switzerland

• Until the crisis the e exchange rate was about 1.6

• Then, Switzerland was seen as a safe haven and moneyflowed in

• Tried to fix the FX in 2011

• Gave in in January 2015www.voxeu.org/article/what-swiss-fx-shock-says-about-risk-models

http://www.voxeu.org/article/what-swiss-fx-shock-says-about-risk-models



CHF/e

2000 2005 2010 2015

1.1

1.2

1.3

1.4

1.5

1.6

1.7

SR

F/E

UR

1.2

1.4

1.6



Why

• If one considers who owns the Swiss National Bank

• And some factors, perhaps• SNB dividend payments• Money supply• Reserves• Government bonds outstanding

• Loss to the SNB about CHF 50 million

• SNB has now $750 billion in stocks, bonds and cash

• $2.7 billion in Apple

• The SNB’s profit last 2016 was SNB 24.5 billion (3,000per Swiss resident)



Does it make sense to manipulate?

• The larger the country the less foreign markets matter

• Most consumption is domestic and because part of that islocal

• Considerable empirical evidence that FX is not all thatimportant for larger countries

• Case study Brexit

• For a small country, the pass-through from FX todomestic prices can be very rapid

• Undermining benefits of manipulating FX

• While creating instability



Reserve Currencies



Reserve currency

• One currency, or asset is reserve currency

• Was gold and sterling. Now US dollar

• Advantages• major products priced in your own currency —

eliminating currency risk. This does not matter, contraryto popular belief

• foreigners hold it as reserves — exchanging real goodsfor paper

• firms (now in US) borrow from global markets in localcurrency

• Make others unhappy• transfers power to the reserve currency country• misbehavior like inflation or QE is tax on other

countries’ reserves



The power of clearing

• All USD transactions are cleared via NY (Fed)• If Iran sells oil to China in USD, funds travel via NYC

• Denial of New York clearing a powerful tool

• Germany’s Foreign Minister has called for alternativeclearing mechanisms

• as have many others



Dollar as reserve currency

• Is it inevitable to have a single reserve currency, and doesit have to be the dollar?

• Interest rates in the US are close to zero, and governmentdebt at historical levels

• Economic growth is anaemic and running a trade deficit

• If the US did not have a reserve currency• it would likely experience a sharp depreciation in its

currency• stimulating exporters and correcting the trade balance



• Because of the reserve status this is not happening

• Foreign countries directly intervene in the FX markets, tobuild up reserves and maintain the dollar rate of exchange

• So, global imbalances build up, other countriesaccumulate vast reserves and the dollar remains artificiallyhigh

• For the US however there is a way out of this — inflation

1. depreciating its currency — stimulate exports2. reducing the real value of its debt — make the foreigners

pay

• No wonder countries like China grumble at QE but thereis not much they can do



US federal government debt(end 2016)Foreign holdings: % of total and billions

$0 $200 $400 $600 $800 $1000

0% 1% 2% 3% 4% 5%

JapanChina, Mainland

IrelandCayman Islands

BrazilSwitzerland

LuxembourgUnited Kingdom

Hong KongTaiwan

BelgiumIndia

Saudi ArabiaSingapore

Korea, SouthRussia

CanadaGermanyThailandBermuda

FranceUnited Arab Emirates

TurkeyNetherlands

NorwayMexico

ItalySweden

PhilippinesSpain

AustraliaPoland

IsraelChile

KuwaitColombiaIndonesia

KazakhstanDenmark

OmanIraq

VietnamMalaysia

PeruFinland



US federal government debtForeign holdings:

2000 2005 2010 2015

0

200

400

600

800

1000

1200JapanChina, MainlandIrelandCayman Islands



Power

• Do the Japanese, Chinese, Brazilian, Russian etc.holdings of US government debt

• Give them power over the US?

• No

• The US gets the power

• It can deflate the debt when it wants

• The other countries cannot sell without encouraging verylarge losses

• Which would not hurt the US much



Real return on US bonds

loss

profit

1900 1920 1940 1960 1980 2000

1

2

5

10



The Chinese renminbi• The reserve status of the US dollar creates significantproblems for China

• Have to keep their currency weak viz. the US dollar

• Reserve status of the dollar facilitates the Chineseundervaluation of the renminbi

• Creating significant domestic problems in China

• For this reason it is no surprise that the biggest championof alternative reserve currencies is China

• With China just about the second–largest economy in theworld, shouldn’t the RMB become the next reservecurrency?

• If China were to abolish capital controls and currencyinterventions, and continue to grow, that eventualitycannot be dismissed



Euro• Recently, there was much talk about the euro becomingthe next reserve currency

• It is the currency of the biggest economic unit in the world

• With the recent difficulties facing the euro, unlikely tohappen anytime soon

• Future of the euro no longer certain

• The European authorities have shown themselves to bepoor stewards of a currency, and therefore unreliable asthe owners of the future reserve currency

• Exam 2019 “The president of the European Commission,Jean-Claude Juncker, recently complained about Europeusing US dollars to pay for oil imported from Russia. Doyou think this complaint is economically sensible?” forclass discussion



Math



The nominal exchange rate The price of one currency interms of another, usually expressed as thedomestic price of the foreign currency

e = 1.36$

e= 0.735

e

$

Real exchange rate (RER) The real exchange rate iscalculated as the nominal exchange rate adjustedfor differences in price levels between countries:

RER = eP∗

P

Economist’s BigMac analysis



Purchasing power parity (PPP)

Absolute PPP the exchange rate of two currencies results inequal purchasing power

et =P∗t

Pt

Relative PPP the change in the nominal exchange rateshould equal the price level differentials of twocountries:

et − et−1

et−1=

Pt−Pt−1

Pt−1−

P∗

t −P∗

t−1

P∗

t−1

1 +P∗

t −P∗

t−1

P∗

t−1



Interest parity

Uncovered interest parity, UIP The expected movement inan exchange rate is equal to the differentialbetween domestic and foreign interest rates

eet− et−1

et−1=

it−1 − i∗t−1

1 + i∗t−1

Or approximately:

it = i∗t+ Et−1∆et

Global Financial Systems Chapter 11 Currency Markets. Part b · • In eﬀect, speculating against...

Documents

Transcript of Global Financial Systems Chapter 11 Currency Markets. Part b · • In eﬀect, speculating against...